Common ESOP Use Cases

Lock and Key

March 5, 2024 David Blauzvern

Employee stock ownership plans are industry agnostic and adaptable enough to meet a range of stakeholder objectives. 

So long as a closely-held company is US-based, has at least three years of continuous operations, and has at least 10 staff in its employee trust, the business can utilize virtually all available ESOP tax advantages.

Company size can matter, and firms with adjusted EBITDAs over $3 million may be better equipped to manage the expenses and reap the full benefits of a leveraged ESOP. This isn’t a hard and fast rule, though. Many factors play-in to the cost-benefit calculus behind an employee ownership strategy. 

Beyond those numbers and statutory requirements, there are a variety of scenarios and unique goals that often drive ESOP consideration.


Six Leveraged ESOP Use Cases and Potential "Good Fits"

Shareholders Taking "Chips of the Table"

Founders and owners often have most of their net worth locked up in their companies. At the same time, many have no intention of selling-out and walking away. Whether they’re too young for retirement, want their firms to remain independent, or they simply enjoy their current work-life balance, a third-party sale is generally out of the question.

Partial ESOP sales offer a meaningful compromise. When shareholders sell a minority stake to an employee trust, they can receive fair market value for their shares, maintain future upside, and keep their day-to-day routine and responsibilities. Furthermore, when at least 30% of outstanding equity is sold to an ESOP, a selling shareholder can defer capital gains taxes on their proceeds.

Post-transaction, an employee-owned company is free to sell additional shares to the ESOP, repurchase stock, make acquisitions, or sell to outside buyers. That represents significant flexibility for owners with extended time horizons. 

Family Business Succession Alternative

Intergenerational transfers have become a rarity. Many family businesses would prefer to remain independent, but younger family members increasingly forge their own career paths, and internal equity sales can carry significant tax burdens. Departing shareholders often need liquidity, so gifting isn’t always a solution.

A leveraged ESOP buyout of individual owners, or entire ownership groups, can help perpetuate a family-owned company’s legacy and set the stage for additional, targeted ownership transfers. How so? The seller note and/or third-party debt that helps facilitate these transactions will temporarily depress a company’s value. Shareholders can use that opportunity to gift retained interest without triggering taxable limits or sell outstanding equity or warrants to family at lower valuations.

The liquidity generated by an ESOP sale enables families to financially prepare for looming estate tax burdens, without having to engage in the forced sales of a closely-held business. As a result, this unique version of shared ownership enables businesses to stay in families, prepare for the future, and remain rooted in their communities. 

Facilitate a Management Buyout

Willing and able management teams often don’t have the financial wherewithal to orchestrate shareholder buyouts. Cash is usually tight, and it’s difficult to independently raise transaction financing. Even in instances where a standard management buyout (MBO) is feasible, unfavorable tax treatment on both sides of the deal can cloud a transaction.

When leveraged ESOP-MBOs are structured, the sponsoring company can negotiate the creation of warrants alongside the sale of stock to an employee trust. Like stock options, warrants are a form of synthetic equity that offer holders the right to buy company shares for a defined period at a set price. This strike price is typically low, as it reflects the business’s depressed valuation, post-transaction.

Selling shareholders are permitted to gift or sell warrants to their management team. This enables a management team to get skin in the game, beyond standard ESOP allocations. Warrants can meaningfully appreciate as the company de-levers and grows, driving real economic value to the company’s new leaders. 

High Payroll Companies

A leveraged ESOP sale creates corporate income tax deductions equivalent to the transaction price. For example, a $10 million stock sale can yield $10 million in write-offs for the sponsor company. But the pace at which those deductions are utilized is tied to a company’s payroll. That puts staffing, professional services, and other labor-intensive firms in a unique position.

An employee-owned business earns a portion of its allotted deductions when the firm makes contributions to their ESOP plan. Contributions are limited to 25% of the company’s annual ESOP-eligible payroll. So, if the firm in question has an $8 million annual W-2 payroll, it can make a $2 million non-cash contribution to the plan and earn $2 million in annual deductions. In other words, the higher the payroll, the faster a company can utilize its overall tax benefits. 

Asset-Heavy Companies

Latent tax liabilities can significantly impact the sale of a trucking, real estate, or equipment-intensive company to a third-party. Asset-heavy firms typically utilize accelerated depreciation to lower their annual income tax burdens. In a typical asset sale, the difference between the market value and the depreciated cost of these assets is taxed at ordinary income rates. This is known as depreciation recapture.

An ESOP deal is a stock sale, not an asset sale. As a result, a properly crafted transaction will not trigger depreciation recapture. That can meaningfully enhance a selling shareholder’s post-tax sale proceeds.

Government Contractors and Other Designated Businesses

When GovCon and related minority, veteran, and woman-owned firms consider M&A options, two issues commonly arise:  the buyer pool is often limited and strategic sales may result in the loss of a valuable set-aside status. These constraints can negatively impact a company’s sale value, if a transaction can be consummated at all.

Minority ESOP sales and even some majority transactions, can be structured to help contractors preserve their status and secure fair market shareholder liquidity events. Furthermore, employee-owned, cost-plus vendors can benefit from an added incentive. ESOP contributions and dividends represent "allowable" expenses and are reimbursed by the government on cost-plus contracts.


Various Intangibles also Drive Employee Ownership Decisions

Unlike most M&A transactions, employee stock ownership plans offer potential benefits that go beyond a standard liquidity event. For many private and family-owned companies, it's hard to pass-up an opportunity to change employees' lives and cement a business legacy. An ESOP can represent the ultimate "thank you" to a workforce, and a broader community, that helped a company rise and flourish.

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